Be faster than a VC in calculating pre-money vs post-money valuation
August 24, 2021
Many entrepreneurs are confused about how to calculate the percentage of their company that an investor gets. Is it based on pre-money valuation or post-money valuation? What is dilution? In this article, we will explain the difference between pre and post-money valuations and offer some tips for calculating dilution.
Let's first understand how companies are valued as a whole.
Understanding market value
Market value is the price an asset fetches in the market. Unlike products that have an MSRP, companies' market value is an unknown number discovered by activity in the market.
Let's assume I have a printing company that has a factory, machines, employees. It also has a customer base with some commercial contracts. How much is this company worth?
You can estimate the company's value by experts or people who model different scenarios. Still, there would not be an agreed-upon value until someone pays for a piece of the company. The value of the company is unknown until such a transaction occurs.
What affects a company's value?
There are many ways to set the value of a company. The most common is by calculating the net present value of future cash flows. This means that anything that would create a higher expectation for more cash generated by the company will cause it to be valued higher and vice versa. Let's say a Chinese car manufacturer hires BMW's chief engineer. While it doesn't have any immediate effect don't the company, one might expect that this would positively affect the company's ability to generate more cash in the future. Thus, the company's value will be higher.
Buying a public company's stock in the stock exchange
A company's share, or stock, represents fractional ownership of that company. A public company is a company whose stocks are traded on the stock exchange.
When you buy a company's stock in the market, it typically doesn't come from the company but instead is bought from someone else. You trade money with this third party in exchange for their shares. The company's fractional ownership is transferred with the stocks. The company whose stock is being traded in the stock market doesn't take part in transactions, but it can impact it.
Each transaction in the stock market sets a price for the company share, which prices the company as a whole. If a company has 1M stocks, and I paid $1000 for one for these stocks today, the value of this company (also referred to as a market cap) is $1B. This is because my stock represents one of a million equal parts of the company. If I manage to sell the same stock in the stock exchange tomorrow for $1200, the company's valuation becomes $1.2B by the new transaction.
The assumption is that all decisions made by players in the public market are made on publicly available information.
Investing in a private company
When investors invest in a private company, they would usually buy its shares from the company directly. Information is not publicly available, and evaluating the company's value will be done based on information provided by the company to the investor.
In private companies, as transactions of the company's shares are much less frequent, most changes in valuation are hidden from sight and only become visible when investment occurs in the company.
Valuing a startup company - the VC game
The valuation of startup companies is a bit different, even from well-established private companies. The company doesn't have any assets yet and needs to raise money before creating some value to investors through its operations. This is what adds a substantial element of risk to startup investing compared to other types of investments.
A venture capitalist is investing only in companies that have the potential of becoming multi-billion dollars in value, and the investment would come in stages.
In most startup investments, the investors would buy a ~20% stake in the company as part of that round. Thus, once you hear a company has raised $x, it is fair to assume its value is $5x. These are just rough numbers that can significantly vary, but they would all be in the same ballpark.
Pre-money vs. post-money valuation - what is the difference
Once a transaction is pitched to an investor, you ask the investor for money. Let's say you ask for $1M. The first question the investor would have in mind is whether they have enough trust in you that you'd be able to take that money and create more value with it. If the answer is "yes," the next question is "at what value?". If the answer is "no," there is not deal regardless of any valuation.
The pre-money valuation is how much your company is valued before the investment was made, based on its current assets, achievements, employees, and commercial status.
The investment is a net sum that is added to the company, creating a new post-money valuation.
Pre money valuation
Post money valuation
$5M + $1M = $6M
Why is pre-money valuation important?
Raising money usually means giving up a portion of ownership in the company. THe pre-money valuation will set how much you'll be giving away to the investor.
How much to ask for when raising funding?
The simple answer is - as much as possible, or more accurately phrased, as much as you assume someone would believe in you.
A college graduate with no experience and a first-time entrepreneur would have difficulty raising $100K to start their business. An experienced entrepreneur might be successful with $5M, and a well-known public figure might get a $1B seed round. It's not what you do, but mostly who you are.
In reality, you should try and build a healthy company. Sometimes, due to industry hypes, entrepreneurs get an opportunity to raise funds in inflatable valuation. It's hard to say no to such offers, but there is a downside which is the future. If the company will need to raise more money in the future (as most companies do), it would have hard time justifying it's inflatable valuation. This may cause a flat round, where the pre-money valuation is equal to the last round's post-money valuation, i.e., the company did not add value using its operations capabilities. Worse, it can cause a downround, where the pre-money valuation is lower than the last round's post-money valuation, i.e., the company has "destroyed" value with it's operations capabilities. Of course that is not the case, and the valuation changed due to investors changing their estimates of the market as a whole, but it doesn't matter. Raising a downround is very hard as it attached difficulties and failure to the company, even if not in its own fault.
Pre-money vs. post-money valuation - the hard way
Geoff Ralston wrote a great piece on seed funding, and he included a way to calculate the ownership. I've copied the explanation below:
"Say you raise $1,000,000 on a $5,000,000 pre-money valuation.
If you also have 10,000,000 shares outstanding, then you are selling the shares at:
$5,000,000 / 10,000,000 = 50 cents per share
and you will thus sell...
resulting in a new share total of...
10,000,000 + 2,000,000 = 12,000,000 shares
and a post-money valuation of...
$0.50 * 12,000,000 = $6,000,000
and dilution of...
2,000,000 / 12,000,000 = 16.7%
This is a great explanation, based on price per share pre-money valuation but we have some suggestions for improvements:
First, you shouldn't state what pre-valuation you're raising in. It would be best if you focused on how much you're raising. If the deal is competitive, you'll be able to part only with 10-15% of your company. If there is only one buyer, that number will go to 25% and even higher (which is very bad for the future o the company)
Second, there is a much easier way to do the calculation, which will make you as fast as the VC in the room.
Pre-money vs. post-money valuation - the easy way
""Say you raise $1,000,000 on a $5,000,000 pre-money valuation. "
Assuming that is the case, the post-money valuation is $6M, and the investor stake in the company is 1/6 = 16%.
This method does not rely on the price per share pre-money valuation. Here is why based on easier numbers to play with:
Forget about pre/post valuations.
You are an investor, and you meet a great team that has an idea and a prototype.
They want to raise $1M.
You agree to give them the money but want 50% of the company for that money. They are only willing to give you 10% of the company for your money.
You negotiate and agree that your $1M will grant you 25% of the company.
If someone looks at this transaction, they can deduce the company's total value to be $4M - $1M got you 25%, so $2M would give you 50%, and $4M will get you the 100%.
Notice I've not mentioned pre/post valuations - only the company's value as it emerges from the transaction.
Now that we know how much money the company is worth - that is the company's valuation.
This valuation emerged only after the investment was made, so this is the post-money valuation. Before that, the valuation is "unknown" To calculate the pre/money valuation - deduct the overall money injected in the round from the post-money valuation.
Going back to the offers we saw on the table:
$1M for 50% creates a $2M company - post valuation, with a pre valuation of $1M.
$1M for 10% creates a $10M company - post valuation, with a pre valuation of $9M.
Once you start to pitch your startup to VCs and the valuation question comes up, you'll be shocked at how fast VCs supposedly calculate pre/post-money valuation.
Don't worry about it.
They are fast because they do it daily, and that is part of the power play.
Take your time, write down the suggested numbers and consider them after the meeting.
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